5 Cs of Credit

What is the Definition of 5 Cs of Credit?

The 5 Cs of credit consist of five diligence topics that lenders must prioritize while determining the creditworthiness of a potential borrower.

Lenders rely on the five Cs of credit to decide whether to approve or deny a given loan application. If the borrower’s application is approved, then the terms of the loan are also determined by the findings derived from the credit analysis.

The objective of the lender is to understand the credit profile of the borrower using qualitative and quantitative metrics such that the risk of incurring a capital loss is reduced.

Credit risk analysis based on the five Cs of credit framework identifies the strengths and weaknesses of each borrower’s application.

However, each lender places a different weight on each factor based on the specific borrower and contextual details of the borrowing, so there is a subjective element to the model.

How Does the 5 C’s of Credit Work?

Before we delve into the risk components of the 5 Cs of credit – a risk analysis system used among lenders – the following list offers a brief introduction to each concept.

1. Character → The credit history and credit score (FICO) of the borrower and perceived trustworthiness.
2. Capacity → The estimated likelihood of the borrower being capable of meeting all interest obligations and repaying the loan in-full at maturity, which is determined using financial ratios to estimate the risk of default.
3. Capital → The total amount of funds that the borrower has on hand, including any capital the borrower already put towards a potential investment.
4. Collateral → The liquid assets belonging to the borrower that can be pledged as collateral to secure a loan. As part of the lending agreement, the collateral can be seized by the lender in the event that the borrower is unable to meet its obligations.
5. Conditions → The current economic state and external market factors (i.e. macro conditions) that could potentially impact a borrower’s ability to repay the loan.

^{The 5 C’s of Credit (Source: Navy Federal Credit Union)}

1. Character in 5 Cs of Credit

Character refers to the borrower’s commitment to uphold their obligation to meet the payments per the lending agreement, irrespective of unforeseen events.

The assessment of a borrower’s character is a bit of a subjective measure, since it is closely tied to integrity and reputation.

Oftentimes, a borrower’s financial state can unexpectedly undergo a sudden change, such as a reduction in income from a job loss or unanticipated medical bills. The lender needs assurance that the borrower will still continue to abide by the lending agreement and meet the required payments on time.

The track record of the borrower tends to be the most insightful data set for lenders to diligence, which can be evaluated via the credit history and credit score of the borrower.

Historical proof of the borrower repaying loans and fulfilling their obligations without irresponsible behavior—i.e. the absence of “red flags” such as late payments and past defaults—are perceived positively by lenders.

If the borrower has worked with the lender in the past, then the existing relationship can also be influential in the lender’s decisions, as well as make the application process quicker.

For example, a private equity firm that has worked with a lender in the past and has built a strong reputation over the years is far more likely to be trusted by the lender for future financing arrangements.

2. Capacity in 5 Cs of Credit

Capacity is the ability of the borrower to generate sufficient income to repay the new loan, with consideration also given to existing debt obligations.

The methods of measuring capacity are thus more objective, where the items considered are generally quantitative, such as the borrower’s monthly income.

For instance, the debt to income ratio is a relevant credit metric that compares the borrower’s monthly debt payments to their pre-tax monthly income. While the target DTI differs by lender, most prefer a DTI around 35% or less to approve the applicant.

The capacity of a borrower can be improved by an increased salary, an additional source of income, and/or the reduction of existing debt.

The lender must also ensure the borrower’s job security and stream of income is stable, which can be confirmed by the employer and the proof of consistent wages (i.e. the borrower is a long-term employee at the company, as opposed to a recent hire).

The reduction of debt is straightforward, since it entails the borrower using discretionary cash to reduce existing debt. In addition, another method is to refinance debt with more favorable terms, e.g. to reduce the monthly payments on an existing loan.

3. Capital in 5 Cs of Credit

Capital encompasses the overall financial position of the borrower, such as the initial capital contribution and the value of the borrower’s savings and assets (i.e. net worth).

One example is the size of the down payment on a mortgage loan, where a greater down payment results in a lower interest rate and more favorable terms.

A larger-sized down payment is proof to the lender about the seriousness of the borrower to repay the entire loan at maturity and service all interest payments. A larger capital contribution indicates to the lender that liquidity is not a concern,given that it is a form of upfront payment.

Other than the capital contribution to the loan, capital also refers to the analysis of the past financial state of the borrower.

The lender will evaluate how stable the borrower’s financial health has progressed over time.

For corporate borrowers, risks such as cyclicality and the ability to withstand an economic contraction are considered here, whereas the risks more applicable to consumers include job security and substantial changes in discretionary income.

4. Collateral in 5 Cs of Credit

Collateral can be pledged by the borrower to secure a loan and receive more favorable terms.

The collateral-backed loan, or “secured loan”, provides the lender with more assurance because the downside risk is reduced.

In the event of default—the worst case scenario —the lien on the collateral means that the lender has a legal claim on the pledged asset of the borrower and can seize it.

The lender is thereby likely to recover the original loan principal, even if the matter becomes more complicated from the borrower filing for bankruptcy protection, as the Court must then first prioritize the claims held by secured lenders.

For example, two of the most common consumer loans are mortgages and auto loans, wherein the collateral consists of the purchased property (i.e. the house and the car, respectively).

5. Conditions in 5 Cs of Credit

Conditions describe the contextual details of the borrower and the current credit environment in which the loan application is considered.

For instance, the specifics behind the requested loan amount and how the borrower intends to use the proceeds from the loan can influence the lender’s decision.

If the borrower needs the funds to start a new business at a time when the economy is at risk of entering a global recession and the proposed business operates in a high-risk industry with secular headwinds, the likelihood of the application being accepted is lower.

The conditions can consist of internal factors including the purpose of the borrowing, or external factors outside the control of the borrower, such as the prevailing interest rates, current economic conditions (or outlook), geopolitical risks, and pending regulatory risks that could negatively impact the borrower.